Emerging Market Debt: It's Time to Get Tactical

By Margè Karner - November 26, 2018

Emerging market (EM) debt—like equities—was the subject of much scrutiny in the third quarter. But I believe that too many investors were painting all EM debt with a very wide brush. Sure, a strengthening dollar and increasingly higher interest rates in the United States will weigh on EM countries generally, but not equally. Why? Because emerging market countries are not all the same. For example, some have more dollar-denominated debt than others.

And then there's this: the EM countries of today aren't like a generation ago. In the past, many of them had fixed exchange rates, and now most have floating rates. That allows for a natural adjustment that helps with the exchange rate and balance of payments.

In this quarter and for the foreseeable future, China is the issue that's keeping me up at night. The escalating trade war with the U.S. is causing turmoil not only in China, but throughout emerging markets as a whole.

Check out my latest video to learn about my EM debt outlook, and what I think about current valuations and how to pick your spots for exposure.

Margè Karner

TRANSCRIPT

I think we have a higher volatility environment compared to last year, moving forward. However, I do think that we are relatively close to the bottom here for emerging markets. The reason is that we have actually had quite a big move, particularly in the currencies. Taking a step back, if we look at what is happening as a class, we have had negative returns mostly through the currency effect in emerging market assets. If you look at the local markets, the local index, that's now down 8% year-to-date. Mostly, that's been driven by currencies. The local currency denominated return is actually positive. That's one thing. On the external side, which is the U.S. dollar denominated debt for emerging markets, we have the sovereign debt down 3% corporate debt down only 1.5% or so. There is a lot of divergence also within emerging market asset classes—not to speak of the different countries. If we again look at the bigger picture in the environment and what's been driving these moves, it's been increasing U.S. rates compared to the rest of the world and the strengthening dollar. Why does that matter for emerging markets?

Well, it matters for the countries that have very large external vulnerabilities. The biggest examples of that this year have been Turkey and Argentina. That's where we've seen the most turmoil. However, for some other markets that don't have these kinds of external vulnerabilities, it is not as big of a problem. We really do have to differentiate between the countries within emerging markets. This year, we have had some fears of contagion, but we actually haven't gotten a lot of contagion if you look back. Again, we had some hot spots within EM. Mostly the countries that have these external vulnerabilities that were quite hurt, like Turkey and Argentina. That's where we've had the big moves. The currencies are down 30%, 40%. However, other countries didn't really follow. We didn't really get the contagion in a big way. The reason for that also is that in the old days, where countries had fixed exchange rates, they didn't have the same kind of adjustment mechanisms. Most of EM, this is what's really changed, is that most of EM now has floating exchange rates. There is this natural adjustment mechanism through the exchange rate and balance of payments that allows countries to adjust.

The potential escalation of trade wars with China is, of course, a top concern for us and for emerging markets as a whole. We still believe that at the end, it is in everybody's interest to find a solution. However, we can have some turmoil in between. So, we watch that situation very, very closely. In terms of if we look at China as a whole, I mean, China is so important for the global economy and of course for many emerging markets. We've seen some moderation in growth in China recently. However, again, we think it's very much within range, and we've seen a significant policy response now from the Chinese government, which we think will be coming through in the data more towards the end of the year. Overall, we still remain constructive on China. We expect the trade issues to be worked out, but we do remain cautious.

The global backdrop is still relatively supported for emerging markets, in our view, and for emerging market debt. We have still high growth. There was some moderation in global growth, but it's from a very high level. Also, in terms of emerging market growth, there have been some dominant revisions, but the growth is still positive in most countries, with just very few exceptions of countries where we have crisis situations. On the other hand, the valuations are much more attractive now than they were early this year in the first quarter. We've had quite a big adjustment in exchange rates. Also, the spreads have adjusted, particularly for some countries, and there is more differentiation—which I think is very important. What I would say though, is that it is very important to continue to be selective. It is, in our view, a very strong case to manage your portfolios actively. Make sure that you pick the right spots to take exposure.

Emerging market debt was the subject of much scrutiny in the third quarter, but Sr. PM Margé Karner believes that too many investors were painting with a very wide brush. Hear her thoughts on current valuations and how to pick your spots for exposure in a Q4 2018 outlook video.

November 26, 2018

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